Banks’ smooth ride about to get bumpy

Canadian banks have been churning out ever higher profits for the better part of two decades, winning the everlasting gratitude of shareholders.

But now in the wake of the worst financial crisis since the Depression and in the face of a slew of headwinds from the troubles around European sovereign debt to tougher capital rules, many observers are questioning their rosy assumptions.

Even in this country where lenders mostly avoided getting caught in the crisis, the industry landscape has changed dramatically from the way it was just five years ago.

“It’s a question of the difference between what the institutions can actually deliver and what the market is expecting,” said Brad Smith, an analyst at Stonecap Securities.

“The market is still expecting a bounce-back to where it was, but there are a lot of structural changes that have happened that are going to make that very, very challenging.

“They basically can’t.”

The most immediate hurdle is the flagging economy. In the Unites States, lenders are hoarding liquidity in anticipation of the end of the government’s quantitative easing strategy dubbed QE2. Ending the support that has kept not only the U.S. but the North American economy going will be like “taking a patient and knocking the crutch out from under one arm,” said Mr. Smith.

Meanwhile the U.S. housing market continues to deteriorate while unemployment levels remain depressed.

Given the United States remains this country’s largest trading partner by far, those problems have a direct impact in Canada.

But not all of our problems have drifted across the border. While the Canadian economy remains moderately healthy, one of the biggest single threats is record consumer debt levels. Analysts say consumers are finally starting to recover from their binge, but the question is whether it’s too late. Now that debt, much of it in the form of residential mortgages, threatens to blow a hole in bank balance sheets.

But the more immediate problem is that the recent pull-back in consumer borrowing has left banks scrambling for business in their core lending operations.

Even though it’s only been going on for a couple of quarters or so, the impact on players has been dramatic, driving up competition and squeezing profit margins like never before.

“Moderating demand is now an established trend and we expect it to continue,” said Rob Sedran, an analyst at CIBC World Markets.

Consider the most recent earnings quarter. Only two banks beat Street expectations — National Bank and Bank of Nova Scotia — largely because of reduced provisions for loan losses. Investors were not impressed.

When Royal’s results came out on May 27, the shares fell $1.79 or 3% to $57.36. Over the past week the trend continued with the shares tumbling more than 3.7% as of Friday’s close, a stunning fall from grace for Canada’s biggest lender.

Canadian Imperial Bank of Commerce slipped $3.30 when the results were announced on May 26. On Friday the shares closed at $78.45, marking a total drop of 7.1%.

It’s not just the players that disappointed the most that got punished.

All the banks have slipped since Bank of Montreal kicked off the season on May 25, helping to drive the S&P/TSX financials services index down nearly 0.6%.

Indeed, bank shares have basically been treading water since the start of the year, well down from their highs in February and March.

Contrast that to the past two decades when earnings increased at 10% annually, driving up share prices with the same regular-as-clockwork consistency. Even now, return on equity for the banks remains in the upper teens — though more recently that’s been due largely to favourable tax rates and credit provisioning, according to Mr. Smith.

But the sputtering economy is only part of the story.

The fat profits of previous decades were driven by a handful of trends, starting with looser regulations in the late 1980s allowing banks to own investment dealers that set off an acquisition spree, as lenders snapped up brokerages and mutual fund companies, consolidating what had been a fragmented industry into the hands of five big banks.
With their scale and cheap funding they were able to transform their capital markets operations into powerhouses.

More recently they began moving into insurance, leveraging their branch networks and financial heft to become formidable players.

In the late 1990s they began testing the waters in securitization, parcelling up credit card debt and auto loans and selling it off to investors in the form of asset-backed securities.

But over the last few years they’ve exhausted the opportunities of the new businesses.

The easy profits in capital markets have been taken and on top of that new regulations have rendered activities such as proprietary trading a whole lot less profitable.

Securitization, another big revenue generator during the boom years, never recovered from the financial crisis and remains a shadow of its former self.

That leaves the banks in a tough predicament. Virtually across their operations demand for their services has either stagnated or even shrunk, yet the market continues to expect consistent earnings growth. They can keep going for a while by aggressively cutting expenses and lowering provisions for credit losses, but they’re quickly running out of room to manoeuvre.

It’s not like the industry didn’t see this coming.

Analysts say declining growth opportunities was the primary motivation that drove Bank of Montreal, Toronto-Dominion Bank and Royal to expand into the United States, and Bank of Nova Scotia to move into South America and Asia.

“The international platforms they’re building are becoming the factor that’s allowed them to offset that slow growth in Canada,” said Mr. Sedran.

But the move outside Canada is no panacea — as the three lenders with U.S. subsidiaries have discovered. Hit with a seriously challenged economy, all three are struggling to make their investments pay off.

“While offering a clear solution to the organic growth challenges in Canada, large-scale acquisitions will also elevate investment risk until sustainable return potential can be meaningfully assessed,” Mr. Smith said.

Bottom line: The wheels have at least temporarily come off the old growth model and it’s far from certain that the industry can find a workable replacement.

So far only Scotia is gaining real traction with its international expansion strategy, said Mr. Smith, who argues that in the coming years, bank performance will start to diverge based on the relative success or failure of their international operations.

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